While pension scheme deficits grew rapidly from 2000 to 2003 and have since been relatively stable, the implications have started to show only recently. Deficits have been a key stumbling block in a number of high-profile corporate deals. In other cases we know that special dividends or share buy-backs have been blocked, although in their nature these events do not tend to hit the headlines. By Tim Keogh, Worldwide Partner of Mercer Human Resource Consulting.
As a result, some observers have concluded that companies with deficits are unsaleable and cannot return capital to shareholders. This is obviously not true – merger and acquisition activity remains at a high level, even for companies managing large pension deficits, as are capital returns. But there is no doubt that recent legislation gives trustees greater negotiating rights, and the Pensions Regulator, with a keen eye on pension security, is ensuring that these rights are exercised.
The FTSE 350 companies had an estimated aggregate deficit of £70 billion at 30 September 2006 (measured under the accounting standard IAS19), which is equivalent to around 4% of market capitalisation, on average. But this average hides a big range – 5% of companies have deficits in excess of 25% of market capitalisation, which typically means that the total fund (as opposed to the deficit) is larger than the operating business. It may also mean that pension scheme members – employees and ex-employees – are the biggest suppliers of debt finance.
Moreover, settling the IAS19 deficit does not allow a company to walk away from its pension scheme. To detach itself from its pension liabilities a company has to fund them on the terms set by insurance companies. On this basis the deficit is usually at least two or three times higher.
For years the position of a pension scheme in the corporate capital structure was legally fudged. There was a commitment to specified payments over a period of time (as with a bond), but the collateral requirements were limited, and the bond could be redeemed on off-market terms at the company's option.
Now this has changed – the only ways out of the full pension commitment are insolvency proceedings, compromise with members, or settlement via an insurance company. And under the new 'Statutory Funding Objective' (SFO), the pension scheme trustees are required to ensure that the company's commitments are covered by collateral, i.e scheme assets, calculated 'prudently'. Consequently, trustees suddenly have a series of blocking powers affecting corporate activity, when previously they were more or less a passive source of finance.
These issues first came to the fore in the context of the creation of the Pensions Regulator in April 2005, tasked with ensuring that corporate activity could not be used as cover for escaping benefit commitments. Its modus operandi is to remind trustees of their powers and of the expectation that they will use those powers. At the same time, the Regulator threatens company directors who try to dodge their commitments with personal liability for the deficit - meaning financial ruin.
The breadth of the Regulator's powers has led companies to queue at its door for 'pre-clearance' of prescribed activities to avoid subsequent sanction. These activities include takeovers and mergers, which involve extra gearing and substantial returns of capital such as special dividends and buyback programmes. The price of approval is often an increase in scheme contributions, usually on the basis of a large lump sum and funding of the remaining deficit over around five years.
This situation is affecting private equity deals and other debt-financed takeovers in particular. This is uncomfortable for many vendors, who may not achieve the prices they could have demanded when the pension scheme was a soft touch. So for a period this was seen as a showstopper, although we believe that price levels are responding and the market is now moving on.
The regulator has focused on deals, with most capital return activity exempt, so long as it is done out of distributable reserves. So while we have seen deals blocked, there has been less impact on dividends.
But this may now change as trustees start to use their powers under the SFO regime. Actuarial valuations are often carried out on a three-year cycle, and only valuations after September 2005 are affected. The valuation process often takes a year or more, so the serious negotiation is just starting in many cases.
The increase in trustee powers is important. Trustees now have considerable power in relation to seeking higher pension contributions, better benefit security, or a more conservative investment strategy. Some of these powers are new, while others were already there, though trustees may not always have felt empowered to use them - but will increasingly do so. An example of this is to threaten to change the investment strategy in the absence of a satisfactory agreement, with adverse implications for expected returns and hence contributions.
Trustees are obliged to assess an employer's ability to fund a scheme and to decide what is 'prudent', which has created a new market in suitable due diligence work. Copying banking practice, trustees will seek protection from any corporate activity that may increase the risk to them, and they might see dividends and buybacks in this light, regardless of the niceties of the distributable reserve calculation.
While the natural corporate reaction will be to resist this, a more collaborative response may follow if the alternative is a much higher cash payment up-front. It is becoming common for the return of substantial cash to shareholders to be accompanied by deficit reduction, just as paying down other debt is often preferred to cash return. Where there is reasonable cash flow, trustee pressure is usually focused on dividend increases and special payments, rather than on maintaining existing levels of dividend.
The price of regaining control over corporate activity and returns to shareholders may be the removal of a significant part of the deficit, either by using available cash resources or refinancing through other borrowing. For a credit-worthy company, this may be no bad thing. There is a tax benefit from borrowing net and investing gross within the pension fund. Credit analysts will not generally see this as an increase in debt, given that the deficit is usually counted as debt for rating purposes. There may be a parent company with access to cheap finance.
Moreover, the Government's pensions lifeboat – the Pension Protection Fund (PPF) – now charges a levy to schemes in proportion to their deficits and creditworthiness. While the accuracy of the credit assessment has been in doubt thus far, the process will doubtless improve so that much of the credit spread incurred in borrowing is offset by reduced levy payments.
There is a small minority of companies whose pension scheme has become too onerous to support. In these cases, the businesses are economically bankrupt, if not technically so. This blocks payment of dividends pending the inevitable restructuring and/or sale, and the pension trustees and Regulator will be key players. As with any distress situation, there is a delicate and possibly painful balance to be struck in salvaging underlying business value and keeping jobs. But these cases are the exception.
For everyone else, the new environment is all about price when it comes to selling the business, and keeping trustees on side when it comes to dividends. The simplest way of keeping trustees on side may be to fund the deficit and borrow elsewhere. Alternatively, this may be a natural and value-enhancing use for spare cash - or the strength of the parent company may be brought to bear. If these solutions are impractical or undesirable, expect the pension trustees to spend more time in your boardroom.
Tim Keogh is Worldwide Partner of Mercer Human Resource Consulting.
Contact: tim.keogh[at]mercer.com
The articles published here in the Thinking CEO are internet updates of the latest management knowledge and practice, which have been commissioned by Sovereign Publications for their bi-annual magazine, CEO Today, and will appear later in the first 2007 issue of this publication. To contact Sovereign and CEO Today, go to:
http://www.sovereign-publications.com/ceo-art.htm
read all 70 gurus with one feed read all Read all media
